CDOs (secured debt obligations) are a type of investment vehicle, or in other words, unregulated asset-backed securities and integrated credit product. These CDOs are created from a portfolio of fixed income assets. The rating agencies evaluate the value of these assets and divide them into different tranches: AAA (senior tranches), AA to BB (mezzanine tranches) and unrated (known as equity tranches). In CDOs, junior tranches provide higher interest rates (coupons). This mechanism is used to offset the associated additional risk of default. Losses are adjusted in reverse order of seniority, that is, the equity tranches bear the first loss adjustment, then the mezzanine tranches, and finally the senior tranches.
Drexel Burnham Lambert Inc. was the first to issue secured debt obligations (CDOs) for a savings institution known as the Imperial Savings Association, which later went bankrupt and was taken over by Resolution Trust Corporation in the 1990s. But later In a decade, with the introduction of Gaussian copula models, CDOs emerged as one of the fastest growing investment vehicle sectors. Growth can be measured by the growing interest in CDOs among investors and asset managers, including investment trusts, mutual fund companies, insurance companies, private banking institutions, pension fund managers, investment banks, commercial banks and other CDOs and integrated investment vehicles. The basic reason for such interest was the higher profit margins.
CDO has a very broad definition and refers to different types of products. They can be classified in the following ways:
Source of funds: cash flow (income) and market value
o Cash flow CDOs pay principal and interest to note holders using the income generated by the CDO’s assets. Its main focus is managing the credit standard of the fundamental portfolio.
o Market value CDOs conduct profitable and regular sale and trading of collateral assets to increase investor income. The asset manager strives for capital gains on the underlying portfolio. They are more concerned with changes and developments in the market value of assets in the CDO portfolio.
Reason: Refereeing and Balance
o Arbitrage transactions seek to gain control over equity investors who are scattered between lower-yielding liabilities and comparatively higher-yielding assets comprised of the rated bonds. Most CDOs are requested by arbitration.
o On the contrary, balance sheet operations are mainly driven by issuers to reduce the credit risk of their balance sheet. Write off loans and other assets from the balance sheet and improve your profitability on risky assets.
Financial support: cash and synthetic
o Cash CDOs require a portfolio of cash value, such as corporate bonds, loans, mortgage-backed securities, or asset-backed securities. Possession of the assets is transferred to the legal entity (SPV), the issuer of the CDO notes. The loss is distributed in reverse order of seniority.
o Synthetic CDOs earn profits on fixed income assets without owning them, through the credit default swap mechanism. Under this swap mechanism, the CDO, the seller of credit protection obtains premiums (periodic cash payment) with an agreement that, in the event of a loss, they would be shared in reverse order of the seniority tranches.
Single slice
o Single tranche CDOs are built using the flexibility of credit default swaps. This CDO is specially designed for small group investors; the remaining sections are not sold, but are kept by the dealer according to some agreed internal models.
The working patterns of all CDOs are almost the same, but differ in structure and underlying assets. Basically, a CDO is a collective entity formed to hold assets as collateral and sell income packages to investors. A CDO is based on the following lines:
o An SPV (special purpose entity) assumes a credit role. They typically hold assets such as commercial real estate debt, mortgage-backed securities, and high-yield corporate loans.
o SPV issues different classes of stocks and bonds and the payments are used to buy the loan portfolio. Stocks and bonds are entitled to income according to the Payment Priority of the pre-transaction documents. The first income goes to the senior tranches together with the junior tranches and finally the capital tranches are paid. Thus, the equity tranches bear the first loss, then the junior tranches and finally the senior tranches. Thus, all tranches have the same portfolio of debt securities, but offer different combinations of return and risk.
A CDO investor does not take a direct position in the underlying assets, but has a position in an entity with a defined reward and risk. Therefore, the investment is subject to the standard of measurements and assumptions involved in the reward and risk analysis of the notes.
Typically, the investment bank (issuer of the CDO) makes a commission upon issuance of the CDO and management fees until the existence of the CDO. Investing in a CDO is an investment in the asset income and metric standards of this broker, rather than a direct investment in the asset-backed collateral.
